Joint Center for Housing Studies
Harvard University
Financial Literacy:
An Essential Tool for Informed Consumer Choice?
Annamaria Lusardi
February 2008
UCC08-11
The author would like to thank Eric Belsky, Keith Ernst, Kevin Rhein, and participants to the conference
“Understanding Consumer Credit: A National Symposium on Expanding Access, Informing Choices, and Protecting
Consumers” for comments and Audrey Brown for research assistance.
© by Annamaria Lusardi. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted
without explicit permission provided that full credit, including © notice, is given to the source.
Any opinions expressed are those of the author and not those of the Joint Center for Housing Studies of Harvard
University or of any of the persons or organizations providing support to the Joint Center for Housing Studies.
Abstract
Increasingly, individuals are in charge of their own financial security and are confronted
with ever more complex financial instruments. However, there is evidence that many individuals
are not well-equipped to make sound saving decisions; that they do not possess adequate
financial literacy. This paper demonstrates widespread financial illiteracy among the U.S.
population, particularly among specific demographic groups. Those with low education, women,
African-Americans, and Hispanics display particularly low levels of literacy. Financial literacy
impacts financial decision-making. Failure to plan for retirement, lack of participation in the
stock market, and poor borrowing behavior can all be linked to ignorance of basic financial
concepts. While financial education programs can result in improved saving behavior and
financial decision-making, much can be done to improve these programs’ effectiveness.
Introduction
Over the past thirty years, individuals have had to become increasingly responsible for
their own financial security following retirement. The shift from defined benefit (DB) to defined
contribution (DC) plans has meant that workers today have to decide both how much they need
to save for retirement and how to allocate pension wealth. Furthermore, financial instruments
have become increasingly complex and individuals are presented with new and ever-moresophisticated financial products. Access to credit is easier than ever before and opportunities to
borrow are plentiful. But are individuals well equipped to make financial decisions. In other
words, do they possess adequate financial literacy to do so?
This paper shows that most individuals cannot perform simple economic calculations and
lack knowledge of basic financial concepts, such as the working of interest compounding, the
difference between nominal and real values, and the basics of risk diversification. Knowledge of
more complex concepts, such as the difference between bonds and stocks, the working of mutual
funds, and basic asset pricing is even scarcer. Illiteracy is widespread among the general
population and particularly acute among specific demographic groups, such as women, AfricanAmericans, Hispanics, and those with low educational attainment.
Financial literacy affects financial decision-making; ignorance about basic financial
concepts can be linked to lack of retirement planning, lack of participation in the stock market,
and poor borrowing behavior. Several initiatives have been undertaken to foster saving and
financial security. The evidence is, in some cases, mixed, but several programs have proven
effective in fostering saving and increasing participation in pension plans. However, much more
can be done to improve the effectiveness of these programs. Furthermore, initiatives should
consider a wider spectrum of financial behavior; for example not only saving, asset allocation,
and pension but also borrowing behavior.
Theoretical Framework
The theoretical framework used to model consumption/saving decisions posits that
rational and foresighted consumers derive utility from consumption over their lifetimes. In the
simplest format, the consumer has a lifetime expected utility, which is the expected value of the
sum of per-period utility discounted to the present from the consumer’s current age to his/her
oldest attainable age. Assets and consumption each period are determined endogenously by
1
maximizing this utility function subject to an intertemporal budget constraint, which represents
the present discounted value of future resources (which include earnings, Social Security, and
pensions). This model posits that the consumer holds expectations regarding discount rates,
investment returns, earnings, pension and Social Security benefits, and inflation. Further, it
posits that the consumer uses that information to formulate and execute optimal
consumption/saving plans. In other words, the consumer looks ahead and plans for the future
taking his/her lifetime resources into account.
Even in this basic formulation of the saving decision, the actual requirements for making
saving decisions are demanding: Individuals have to collect information and make forecasts
about many variables, from Social Security and pensions to interest rates and projected inflation,
to name just a few. Moreover, they have to perform calculations that require, at minimum, an
understanding of compound interest and the time value of money. Decisions about how much to
accumulate and how much to borrow to be able to smooth consumption over the life-cycle also
require an understanding of the working of interest rates.
Do individuals possess the level of financial knowledge and numeracy necessary to
perform the calculations mentioned above? Does saving and borrowing behavior follow the
predictions of these simple models? While financial literacy has often been overlooked in
previous studies, it can be an important predictor of financial behavior. The next section provides
an examination of the level of literacy individuals possess.
Basic and Advanced Financial Literacy
Basic Financial Literacy
Several surveys exist that report information on financial knowledge in sub-groups or
among the whole U.S. population.2 However, these surveys rarely provide information on
variables related to economic outcomes such as saving, borrowing, or retirement planning. In an
effort to combine data on financial literacy with data on financial behavior, Lusardi and Mitchell
(2006) have pioneered inserting questions measuring financial literacy into major U.S. surveys.
They first designed a special module on financial literacy for the 2004 Health and Retirement
Study (HRS); this module has now been added to the National Longitudinal Survey of Youth
(NLSY). These and other questions measuring financial knowledge have also been added to the
2
2
See Lusardi and Mitchell (2007b) for an overview of these surveys.
Rand American Life Panel (ALP) and to other surveys covering specific sub-groups of the
population.3 The addition of these types of questions to existing surveys not only allows
researchers to evaluate levels of financial knowledge but, most importantly, makes it possible to
link financial literacy to a rich set of information about household financial behavior.
Given the limited number of questions that can effectively be added to surveys,
researchers have to assess financial literacy from only a handful of questions. But which
questions should be asked to determine whether respondents possess financial literacy?
Moreover, which data allow researchers to most accurately assess the effect of literacy on
behavior? As will be reported below, it is possible to gauge financial knowledge from a small set
of questions. However, to assess the effect of knowledge on behavior, researchers need
information about variables other than respondents’ current levels of financial literacy.
The three questions Lusardi and Mitchell (2006) devised for the HRS measure basic but
fundamental concepts relating to financial literacy, such as the working of interest rates, the
effects of inflation, and the concept of risk diversification. The questions are as follows:
1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5
years, how much do you think you would have in the account if you left the money to grow:
more than $102, exactly $102, less than $102?
2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2%
per year. After 1 year, would you be able to buy more than, exactly the same as, or less than
today with the money in this account?
3. Do you think that the following statement is true or false? “Buying a single company stock
usually provides a safer return than a stock mutual fund.”4
The first two questions (compound and inflation) evaluate whether respondents display
knowledge of fundamental economic concepts and competence with basic financial numeracy.
The third question (stock risk) evaluates respondents’ knowledge of risk diversification, a crucial
element of any informed investment decision.
The HRS sample covers respondents who are 50 or older, with the average age being 65.
Results from this survey module reveal an alarmingly low level of financial literacy among older
3
These questions have been added to a survey of participants to the state employees plan in the state of Nebraska
(Medill 2007). Moreover, they have been added to the 2005 Dutch DNB Household Survey (van Rooij, Lusardi and
Alessie 2007), and a 2007 pilot survey of participants in Mexico’s privatized Social Security plan (Hastings 2007).
4
In addition to the list of answers provided above, respondents can also choose that they do not know the answer to
the question (DK), or they can refuse to answer (refusal).
3
individuals in the United States. Only 50 percent of respondents in the sample were able to
correctly answer the first two questions, and only one-third of respondents were able to answer
all three questions correctly. The question that was most difficult for respondents to answer was
the one about risk diversification; more than one-third of respondents reported they did not know
the answer.5 Not only is the finding that most respondents do not grasp the concept of risk
diversification an important one, but posing difficult questions allows researchers to differentiate
among different levels of financial sophistication, even when using a limited number of
questions to measure financial literacy
Lusardi and Mitchell (2007a) have also examined numeracy and financial literacy among
a younger segment of the population, the Early Baby Boomers, who were 51 to 56 years old in
2004. This segment of the population is particularly useful to study as respondents in this age
group should be close to the peak of their wealth accumulation and should have dealt with many
financial decisions already (mortgages, car loans, credit cards, pension contributions, etc.). The
following questions were posed to these respondents in the 2004 HRS:
1. If the chance of getting a disease is 10 percent, how many people out of 1,000 would
be expected to get the disease?
2. If 5 people all have the winning number in the lottery and the prize is 2 million
dollars, how much will each of them get?
For respondents who answered either the first or the second question correctly, the following
question was asked:
3. Let’s say you have 200 dollars in a savings account. The account earns 10 percent
interest per year. How much would you have in the account at the end of two years?
Table 1 summarizes how Early Boomers answered these questions. Again, numeracy is
found to be low among respondents; only about half could divide $2 million by 5. Moreover, the
large majority did not have a good grasp of the power of interest compounding: only 18 percent
correctly computed the compound interest question. Of those who got the interest question
wrong, 43 percent undertook a simple interest calculation, thereby ignoring the interest accruing
on both principal and interest. These are not comforting findings, especially considering that
these respondents have already dealt with many financial decisions during their lifetimes.
5
4
See Lusardi and Mitchell (2006) for details.
These findings are confirmed in several other studies. Bernheim (1995, 1998) was one of
the first to emphasize that most individuals lack basic financial knowledge and numeracy.
Lusardi and Mitchell (2007b) and Smith and Stewart (2008) survey the evidence on financial
literacy in the United States and in other countries and report similar findings. Lusardi and
Tufano (2008) report that the vast majority of respondents in a representative sample of U.S.
households have limited knowledge of the power of interest compounding.
Advanced Literacy
To competently make saving and investment decisions, individuals need knowledge
beyond the fundamental financial concepts discussed above, including understanding the
relationship between risk and return; how bonds, stocks, and mutual funds work; and basic asset
pricing. To quantify how knowledgeable individuals are in this area, Lusardi devised several
additional questions for the ALP. Most of these questions had earlier been added to the Dutch
DNB Household Survey6 and are similar to questions used in other U.S. surveys.7 Because the
question about risk diversification had been found to be hard to answer, it was included in the set
of questions on advanced financial literacy.
The exact wording of these questions is as follows:
1. Function of Stock Market
Which of the following statements describes the main function of the stock market? (i) The
stock market helps to predict stock earnings; (ii) The stock market results in an increase in
the price of stocks; (iii) The stock market brings people who want to buy stocks together
with those who want to sell stocks; (iv) None of the above; (v) DK; (vi) Refuse.
2. Knowledge of Mutual Funds
Which of the following statements is correct? (i) Once one invests in a mutual fund, one
cannot withdraw the money in the first year; (ii) Mutual funds can invest in several assets, for
example invest in both stocks and bonds; (iii) Mutual funds pay a guaranteed rate of return
which depends on their past performance; (iv) None of the above; (v) DK; (vi) Refuse.
6
See van Rooij, Lusardi, and Alessie (2007) for a detailed explanation and review of these questions.
Specifically, questions were taken from the National Council of Economic Education Survey, the NASD Investor
Knowledge Quiz, the 2004 Health and Retirement Study module on financial literacy and planning, the Survey of
Financial Literacy in Washington State, and the 2001 Survey of Consumers.
7
5
3. Relationship Between Interest Rates and Bond Prices
If the interest rate falls, what should happen to bond prices? (i) Rise; (ii) Fall; (iii) Stay
the same; (iv) None of the above; (v) DK; (vi) Refuse.
4. Risk Diversification: Company Stock or Mutual Fund?
True or false? Buying a company stock usually provides a safer return than a stock mutual
fund. (i) True; (ii) False; (iii) DK; (iv) Refuse.
5. Riskier: Stocks or Bonds?
True or false? Stocks are normally riskier than bonds. (i) True; (ii) False; (iii) DK; (iv)
Refuse.
6. Long Period Returns
Considering a long time period (for example 10 or 20 years), which asset normally gives
the highest return? (i) Savings accounts; (ii) Bonds; (iii) Stocks; (iv) DK; (vi) Refuse.
7. Highest Fluctuations
Normally, which asset displays the highest fluctuations over time? (i) Savings accounts;
(ii) Bonds; (iii) Stocks; (iv) DK; (v) Refuse.
8. Risk Diversification: Spreading Money Among Different Assets
When an investor spreads his money among different assets, does the risk of losing money:
(i) Increase; (ii) Decrease; (iii) Stay the same; (iv) DK; (v) Refuse.
The average age of the ALP sample is about 53, and most respondents are between the
ages of 40 and 60. The sample is composed mostly of highly educated (over half have at least a
college education) and high-income (almost 30 percent earn $100,000 or more) respondents.
This sample characteristic is partly due to the fact that the survey is done online, and frequent
internet users are not a representative sample of the U.S. population. Yet it is useful to see how
these respondents fare when asked questions about financial concepts they should have dealt
with in their financial decisions.8
Responses to the more complex battery of advanced financial literacy questions are
summarized in Table 2. Panel A shows that most respondents, over three-quarters, do get most of
the answers right, so they have some knowledge of how the stock market and risk diversification
work. They are also more likely to be knowledgeable about fluctuations in assets than they are
about patterns of asset returns. But only about one-third of the sample knows about the
8
6
See Lusardi and Mitchell (2007c) for details.
relationship between bond pricing and interest rates, indicating striking ignorance of how assets
are priced.9 Moreover, while the large majority of respondents responded correctly to several of
the more advanced questions, only one-fifth of respondents were able to answer all of these
questions correctly (Table 2, panel B). Thus, advanced knowledge is not widespread, even
among a sample of highly educated respondents.10
Several other surveys covering the U.S. population or specific sub-groups have also
documented low levels of advanced financial knowledge across the age spectrum. For example,
data from five surveys from the Jump$tart Coalition for Personal Financial Literacy spanning
from 1997 to 2006 show that only a small minority of high school students score above a passing
grade in financial literacy. Low scores are not only pervasive among high school students but
have changed little over time (Mandell 2008). These findings are confirmed by the National
Council of Economic Education (NCEE), which periodically surveys high school students and
working-age adults to measure financial and economic knowledge. The NCEE survey consists of
a 24-item questionnaire on topics including “Economics and the Consumer,” “Money, Interest
Rates, and Inflation,” and “Personal Finance.” Adults got an average score of C on these
questions, while the high school population fared even worse, with most earning an F. Hilgert,
Hogarth, and Beverly (2003) examine data from the 2001 Survey of Consumers, where some
1,000 respondents (ages 18–98) were given a 28-question true/false financial literacy quiz
covering knowledge about credit, saving patterns, mortgages, and general financial management.
Again, most respondents earned a failing score on the quiz, documenting widespread illiteracy
among the population. Similar findings are reported in smaller samples or specific groups of the
9
Very similar findings are provided by Moore (2003), which also reports that the fraction of correct responses to
questions measuring sophisticated knowledge is very low.
10
When levels of literacy are low, one may wonder whether respondents even understand the meaning of the
questions they are asked. To investigate whether the wording of questions matters, two randomly chosen groups of
respondents to the ALP were posed the same questions but with different wording. This was implemented for three
questions: a rather simple question about the risk differences between bonds and stocks (a first group was asked:
“Stock are normally riskier than bonds; true or false?” while a second group was asked: “Bonds are normally riskier
than stocks; true or false?”); a more difficult question about risk diversification (a first group was asked: “Buying a
company stock usually provides a safer return than a stock mutual fund; true or false?” while a second group was
asked: “Buying a stock mutual fund usually provides a safer return than a single company stock; true or false?”); and
the most difficult question about the link between bond prices and interest rates (a first group was asked: “If the
interest rate falls, what should happen to bond prices?” and a second group was asked: “If the interest rate rises,
what should happen to bond prices?”). The wording of the question did not matter for the first two questions, but it
did matter for the third question, showing a fair amount of guessing and measurement error in the responses to
complex financial literacy questions. See Lusardi and Mitchell (2007c) for details.
7
population (Agnew and Szykman 2005). Moore (2003) examines financial literacy in
Washington State and reports low levels of financial knowledge in that state.
Who Is Financially Literate?
Financial illiteracy is not only widespread, it is particularly acute among specific
demographic groups. For example, financial literacy, as measured by the three questions in the
2004 HRS module, declines strongly with age/cohorts (Figure 1). This is an important finding as
individuals are required to make financial decisions until late in the life cycle and there is
mounting concern about the incidence of financial scams that prey upon the elderly. There are
sharp gender differences in financial literacy, with women displaying a lower level of knowledge
than men, particularly with regard to risk diversification (Figure 2). Lusardi and Mitchell (2008)
examine this issue in more detail and warn about the difficulties women may face in making
financial decisions, particularly after the death of a spouse.
Financial literacy varies widely among education groups. Only half of respondents with
less than a high school correctly answer the question requiring a simple calculation of interest
rates, and close to 20 percent state they do not know the answer to this question. The large
majority of those without a college degree do not know or answer incorrectly the question about
risk diversification. Similarly, there are major differences in financial literacy across racial
groups, with African-Americans and Hispanics displaying much lower levels of financial literacy
than whites. Approximately half of African-Americans correctly answer the question about
interest rate calculations, and the proportion of correct answers is even smaller among Hispanics.
Lusardi and Mitchell (2007a) document similar findings when using different measures of
literacy among a sample of Early Baby Boomers.
These results are not specific to the age groups covered in the HRS, but are common to
many other surveys on financial literacy.11 Moreover, the findings outlined above are already
present among young respondents. For example, Mandell (2008) focuses on a small group of
students who are defined as being financially literate (all had received a score of 75 percent or
more on a financial literacy test) in the 2006 Jump$tart Coalition survey. Note that this group
represents a tiny fraction of the whole sample: only 7 percent. The financially literate students
11
8
See Lusardi and Mitchell (2007b) for a review.
are overwhelmingly white, male, and the children of college graduates. Thus, the correlation
between literacy and gender, race, and education is present at early stages of the life cycle.
Lusardi and Mitchell (2007c) show that financial literacy is highly correlated with
exposure to economics in school. Those who studied economics (in high school, college, or at
higher levels) were much more likely to display higher levels of financial literacy later in life, a
finding which is also present in data from other countries.12 They use this information to assess
the impact of financial literacy on financial behavior later in life. Because financial literacy can
be affected by experience with saving and investing—learning by doing—data on literacy early
in life (or on other determinants of financial literacy) is necessary to evaluate the impact of
literacy on financial behavior, as will be explained in the next section.
Does Financial Literacy Matter?
As mentioned earlier, one of the major advantages of inserting questions about financial
literacy in major U.S. surveys is that researchers can assess whether literacy influences financial
decision-making. Table 3 displays the relationship between financial literacy and retirement
planning. As shown by Lusardi (2003), Lusardi and Beeler (2007) and Lusardi and Mitchell
(2007a), retirement planning is a powerful predictor of wealth accumulation; those who plan
have more than double the wealth of those who have not done any retirement planning.
Financial literacy matters for planning: Those who are more financially knowledgeable
are much more likely to have planned for retirement. In terms of economic importance, both the
knowledge of interest compounding and the ability to perform simple calculations (such as a
lottery division) are the strongest predictors of planning. This is to be expected, given that any
saving plan requires some numeracy, the ability to calculate present values, and an understanding
of the advantages of starting to save early in life. Financial literacy is not simply a proxy for low
education, race, or gender; as has been noted, women, minorities, and those with low education
are disproportionately less likely to be financially literate. Even after accounting for many
demographic characteristics, Table 3 (column III) shows that financial literacy continues to be an
important determinant of planning.13
12
13
See van Rooij, Lusardi, and Alessie (2007).
See, also, Lusardi and Mitchell (2006).
9
One may argue that financial literacy and retirement planning are both decision variables
and that the act of planning may enhance financial knowledge. In other words, those who want to
plan for retirement may invest in acquiring financial knowledge. To evaluate the relationship
between literacy and planning, it is important to have information beyond individuals’ current
levels of financial literacy. Lusardi and Mitchell (2007c) use information on individuals’ past
financial literacy, prior to their entering the job market. They find that those who were
financially literate when young are more likely to plan for retirement, showing that it is literacy
that affects planning and not the other way around.
Advanced financial literacy also matters for financial decision-making. Van Rooij,
Lusardi, and Alessie (2007) use questions they designed for a module on financial literacy for the
Dutch DNB Household Survey to show that financially sophisticated households are more likely
to participate in the stock market. They address the argument that participation in the stock
market or success in investing may also influence financial knowledge by relying on individuals’
financial knowledge in the past and prior to investing in the stock market. They find that those
who were literate when young are more likely to invest in stocks, again showing there is an
independent effect of literacy on stock market participation.
Other studies have confirmed the positive association between financial knowledge and
household financial decision-making. Stango and Zinman (2007) show that those who are unable
to correctly calculate interest rates out of a stream of payments end up borrowing more and
accumulating lower amounts of wealth. Lusardi and Tufano (2008) find that those who severely
underestimate the power of interest compounding are more likely to end up with excessive
amounts of debt. Brown, Casey, and Mitchell (2007) show that those who are more financially
literate are more likely to annuitize rather than take retirement wealth as a lump sum. Agarwal et
al. (2007) show that financial mistakes are most prevalent among the young and the elderly—
demographic groups that display the lowest levels of financial knowledge and cognitive ability.
Hilgerth, Hogarth, and Beverly (2003) also document a positive link between financial knowledge
and financial behavior. Campbell (2006) further demonstrates that many investors failed to
refinance their mortgages during a period of falling interest rates. This finding is consistent with
lack of literacy, as those who failed to refinance were disproportionately investors with low
education. Those investors also seem less likely to know the terms of their mortgages, including
10
the interest rates they pay (Bucks and Pence 2006 and Moore 2003). Moore (2003) also shows that
borrowers who took out high-cost mortgages display little financial literacy.
Financial Education14
As additional evidence that financial illiteracy is a severe impediment to saving, both the
government and employers have promoted financial education programs. Most large firms,
particularly those with DC pensions, offer some form of financial education programs (Bernheim
and Garrett 2003). The evidence to date on the effectiveness of these programs is mixed.15 Only
a few studies find that those who attend financial education programs, such as retirement
seminars, are much more likely to save and contribute to pensions (Bernheim and Garrett 2003
and Lusardi 2002, 2004).
Clearly, those who attend seminars are not necessarily a random group of individuals.
Because attendance is voluntary, it is likely that workers who attend already have a proclivity to
save, and it is hard to disentangle whether it is seminars per se or the characteristics of seminar
attendees that explain the higher saving rates of attendees shown in the empirical estimates.
However, Bernheim and Garrett (2003) argue that seminars are often remedial, i.e., offered in
firms where workers do little or no saving. If this is the case, the effect of seminars is likely to be
underestimated with conventional estimation methods.
Lusardi (2004) uses data from the HRS and confirms the findings of Bernheim and
Garrett (2003). Consistent with the fact that seminars are remedial, she finds that the effect of
seminars is particularly strong for those at the bottom of the wealth distribution and those with
low education. As shown in Table 4, retirement seminars are found to have a positive effect
mainly in the lower half of the wealth distribution and particularly for those with low education.
Estimated effects are sizable, particularly for the least wealthy, for whom attending seminars
appears to increase financial wealth (a measure of retirement savings that excludes housing and
business equity) by approximately 18 percent.16 Note also that seminars affect not only private
14
This part summarizes the evidence and discussion provided by Lusardi (2004). For an analysis of the different
programs and approaches to promote saving and financial security, see also Lusardi (2007).
15
See Lusardi (2004) and Lusardi and Mitchell (2007b) for a review of the effectiveness of financial education
programs, and Hogarth (2006) for a description of many financial education programs currently offered in the
United States.
16
Moreover, Lusardi (2005) uses the supply of retirement seminars to pin down the direction of causality between
seminars and saving. Specifically, she uses the proportion of large firms across states as an instrument for retirement
11
wealth but also measures of wealth that include pensions and Social Security wealth, perhaps
because seminars provide information about pensions and encourage workers to participate and
contribute (Gustman, Steinmeier, and Tabatabai 2008).
One can also learn from the experience of Individual Development Accounts (IDAs),
which are subsidized savings accounts targeted to the poor. One of the features of IDAs is that they
require general financial education; participants are offered several hours and sessions of financial
education. Financial education proves effective and is associated with a sizable increase in savings
among IDA participants (Schreiner and Sherraden 2007). However, the effect of education is nonlinear; after 10 hours of education, there seem to be no additional discernible effects on saving
(Sherraden and Boshara 2008). This suggests that the payoff in financial education can be reaped
by offering a sizable, yet limited, number of financial education sessions.
In addition to fostering saving among the poor, financial education can affect behavior
toward debt. For example, there is some evidence that financial counseling can be effective in
reducing debt levels and delinquency rates (Hirad and Zorn 2001 and Elliehausen, Londquist,
and Staten 2007).
Clark and D’Ambrosio (2008) have examined the effects of seminars offered by TIAACREF to a variety of institutions. The objective of the seminars is to provide financial
information that would assist individuals in the retirement planning process. Their empirical
analysis is based on information obtained in three surveys: participants completed a first survey
prior to the start of a seminar, a second survey at the end of a seminar, and a third survey several
months later. Respondents were asked whether they had changed their retirement age goals or
revised their desired levels of retirement income following attendance of a seminar.
After attending a seminar, several participants stated an intent to change their retirement
goals and many revised their level of retirement income. While a small percentage of respondents
changed their desired retirement age, more than a quarter altered their retirement income goals,
showing that the information provided in the seminars did have some effect on behavior. Women
were particularly receptive to information presented in the seminars. Before attending the seminars,
women reported less confidence in their ability to attain their retirement goals than men. But
women were substantially more likely than men to increase their expected retirement age and also
seminars. She finds that those who are more likely to be exposed to retirement seminars because they live in states
with a high proportion of big firms accumulate more wealth.
12
to alter their retirement goals. Thus, women seem more responsive to financial education, perhaps
because, as reported earlier, they are less likely to be financially literate.
A finding that is common when studying the effects of financial literacy programs, and
which is highlighted in the work of Clark and D’Ambrosio (2008) is that, for many participants,
intentions do not translate into actions. When surveyed several months later, many of those who
had intended to make changes to their retirement plans had not implemented them. Thus,
financial education programs may be of limited effectiveness in the short run; it may take several
months or years for programs to work. Moreover, it may be important to find ways to more
effectively stimulate an active choice among seminar participants.17
Overall, the evidence reported by Bernheim and Garrett (2003), Lusardi (2002, 2004) and
Clark and D’Ambrosio (2008) show that financial education can affect behavior. However,
other papers have reported more modest effects of education programs. Duflo and Saez (2003,
2004) investigate the effects of exposing employees of a large not-for-profit institution to a
benefit fair. This study is notable for its rigorous methodology; a randomly chosen group of
participants was given incentives to participate in the benefit fair, and their behavior was
compared with that of another similar group, which was not offered incentives to attend the fair.
This methodology overcomes the problem mentioned before that those who attend education
programs may already be inclined to save. This is clearly important, and findings from this study
show that the benefit fair induced participants to increase their participation in pensions, but the
effect on saving was almost negligible. Perhaps the most relevant result of this study is how
pervasive peer effects are; not only participants but also their colleagues who did not attend the
benefit fair were affected by it, providing evidence that individuals rely on the behaviors of
those around them in making financial decisions, a finding documented in many other studies
(Brown et al. 2007 and Hong, Kubik, and Stein 2004).18
Financial education programs deliver disappointing results among high school students.
As reported by Mandell (2008), students who took courses in financial management or personal
finance did not do any better on financial literacy tests than students who did not take any such
course. This finding does not seem to be explained by either the quality of the students who
17
See Lusardi, Keller and Keller (2008) for an alternative program aimed to stimulate an active choice among new
hires at a not-for-profit institution.
18
For a discussion of the tools and sources of advice that individuals use to make financial decisions, see Lusardi
(2007).
13
enroll in such courses, the training of the teachers, or the quality of the courses. However, a
specific school-based educational program that is consistently related to higher financial literacy
scores is the stock market game. Those who play a stock market game in class do three to four
percentage points better than all students on financial literacy tests. This may provide some
guidance on how literacy courses could be improved upon.
Discussion and Implications for Public Policy
As shown throughout this paper, the existence of financial literacy should not be taken
for granted. Financial illiteracy is widespread and particularly acute among specific groups,
including those with low education, women, and minorities. Given the increased complexity of
day-to-day financial transactions, the evidence of illiteracy raises important questions for policy.
The mixed evidence on the effectiveness of financial education programs has led some to
question whether it is worth trying to improve financial literacy. In fact, it is not clear there is
even a choice. As it was impossible to live and operate efficiently in the past without being
literate, i.e., knowing how to read and write, so it is very hard to live and operate efficiently
today without being financially literate. Given the complexity of current financial instruments
and the financial decisions required in everyday life, from comparing credit card offerings, to
choosing methods of payments, to deciding how much to save, where to invest, and how to get
the best loan, individuals need to know how to read and write financially.
Note that, as with reading and writing, the objective of any policy designed to promote
financial literacy should be basic knowledge. While it may not be feasible to transform
financially illiterate people into sophisticated investors, it may be possible to teach them a few
principles about the basics of saving and investing. Moreover, as illiteracy was not eradicated
with a handful of lessons or in a matter of months, so financially illiteracy cannot be eradicated
with a few seminars or one benefit fair.
Set in this framework, it is clear that some standards for financial literacy are needed.
What do people need to know? What should the pillars of financial literacy programs be? Setting
these standards will be the backbone of devising financial education programs. There are obvious
benefits to having one institution that presides over or establishes those standards, and the U.S.
Department of Treasury seems an obvious candidate for this role.
14
Technology makes it possible to use interactive methods to teach. Thus, “students of
financial literacy” do not necessarily have to attend classes at school, but can learn from courses
online (or from CDs or DVDs) from their homes. Courses can be customized and tailored to
various needs and levels of financial knowledge. Moreover, as the evidence on the effectiveness
of the stock market game in high schools seems to suggest, it may be important to find ways to
make courses engaging and to stimulate interest in acquiring financial literacy.
New ideas also deserve consideration. For example, as discussed by Sherraden and
Boshara (2008), it is not necessarily the case that people first become financially literate and then
save and accumulate assets. It may also be that, when people begin to accumulate assets, they
become more interested in improving their literacy. Thus, providing economic incentives, such
as a small fund for children’s education or for retirement, may be one way to encourage people
to become financially literate.
Moreover, as mentioned earlier, illiteracy can be linked to financial mistakes. A few
studies have hinted at financial illiteracy as a determinant of excessive borrowing or attaining
high-cost mortgages, but we need more research analyzing the effect of literacy on credit and
borrowing behavior. The problem of financial mistakes seems so pressing that some credit card
companies have taken the unusual step of offering financial education to new-to-credit and atrisk consumers (Brown and Gartner 2007). Early intervention may be a more promising
approach than providing counseling during or after bankruptcy, and these initiatives deserve
some attention.
If people with low literacy make mistakes, who will pay for these mistakes? The
individual, or society at large? If taxpayers will be asked to support those who have made
mistakes, there is a role for regulation and for implementing “mandatory” programs. One such
program could be to require people to obtain some basic financial knowledge (Alesina and
Lusardi 2006). In the same way people are required to have a driving license before they venture
out on the road, a “financial license” could be required before individuals contribute to their
pensions, invest their pension assets, or borrow to buy a house. In this way, individuals may
learn about some basic financial concepts and may reduce their reliance on random advice and
potentially misleading tips from those around them.
Several initiatives have been undertaken in other fields with the objective of “educating”
consumers, and they provide suggestions for financial education as well. For example, in the
15
field of health, guidelines have been offered on how to eat well. In the same way that a “food
pyramid” provides general information about how people should eat, a “saving pyramid” could
provide general guidelines on how to save and invest. Principles such as diversification of
investments, exploitation of the power of interest compounding, taking advantage of tax-favored
assets or employer matches are fundamental concepts that can benefit every investor. Clearly,
there is already a lot of information on these topics. However, as there are many books about
diets, so there are many books about how to save and invest, and it may be worthwhile to provide
a “seal of approval” from experts in the field. For example, one official website that people can
turn to may be more powerful than the many websites that are now available and for which there
are no guarantees about quality.
Given the current low levels of financial literacy, employers and the government should
devise and encourage programs that simplify financial decision-making as well as provide
sources of reliable financial advice. One way to reduce the barriers that individuals face when
making saving decisions is to simplify their planning process.19 For example, Lusardi, Keller and
Keller (2008) used a social marketing approach to develop a planning aid to motivate and
encourage new hires at a not-for-profit institution to open and contribute to supplementary
retirement accounts. The planning aid they designed displays several interesting features. First, it
breaks down the process of enrollment in supplementary pensions into several small steps,
describing to participants exactly what they need to do to be able to enroll online. Moreover, the
aid provides several pieces of information to help overcome barriers to saving, such as
describing the low minimum amount of income employees can contribute (in addition to the
maximum) and indicating the default fund that the employer has chosen for them (a life-cycle
fund). Finally, the planning aid contains pictures and messages designed to motivate participants
to save.
The planning aid was designed following thorough data collection. Lusardi, Keller and
Keller (2008) devised a survey asking explicitly about barriers to saving, sources of financial
advice, and level of financial knowledge and attractive features of a pension plan. They
conducted focus groups and in-depth interviews (with both employees and human resources
administrators) to shed more light on the impediments to saving. These data-collection methods,
19
See Choi, Laibson and Madrian (2006) for the analysis of another program that relies on simplifying decisionmaking.
16
common in the field of marketing, are well suited to capturing the wide heterogeneity relating to
individuals’ saving decisions. The program was very successful; contribution rates to
supplementary pensions tripled after the introduction of the planning aid.
The results of this program have implications for financial education programs and
policies to foster saving. First, while economic incentives such as employer matches or tax
advantages may be useful, there are many more methods that can be employed to make people
save. In fact, given the massive lack of information and lack of financial knowledge that exists in
the general population, implementation of programs aimed at simplifying saving decisions might
be a more cost-effective alternative than tax incentives. Second, individuals are most prone to
decision-making in specific time periods. For example, the start of a new job pushes people to
think about saving (often because they have to make decisions about their pensions), and it may
be very important to exploit such “teachable moments.” Third, to be effective, programs have to
recognize the many differences among individuals, not only in terms of preferences and
economic circumstances but also of their existing levels of information, financial sophistication,
and ability to carry though with plans. In other words, relying on “one-size-fits-all” principles
can lead to rather ineffective programs.
While the problems are many and the challenges are daunting, programs can be designed
to change saving behavior. We have a wealth of information to rely on, and that information
should make effective financial education increasingly possible. In the current economic
environment it is essential to equip consumers with the necessary tools to make informed
financial choices. One of these tools is financial literacy.
17
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21
Table 1: Financial Literacy Among Early Baby Boomers
Question Type
Percentage
Calculation
Lottery
Division
Compound
Interest*
Correct (%)
83.5
Incorrect (%)
13.2
Do Not Know (%)
2.8
55.9
34.4
8.7
17.8
78.5
3.2
Note: *Conditional on being asked the question. Percentages may not sum to 100 due to a few respondents who
refused to answer the questions. Observations weighted using HRS household weights. The total number of
observation is 1,984. Adapted from Lusardi and Mitchell (2007a).
Table 2A. Advanced financial literacy
Weighted percentages of total number of respondents (N=812)
___________________________________________________________________________________
Correct
Incorrect Do not
Know
______
_______
_____
1) Which statement describes the main function of the stock market? 1)
75.5
17.7
6.8
2) Function of mutual fund. 1)
72.4
11.3
16.3
3) If the interest rate falls/rises, what should happen to bond prices: 36.7
rise/fall/stay the same/none of the above? 2)
41.1
22.2
4) Buying a company fund/stock mutual usually provides a safer return than 80.2
a stock mutual fund/a company fund. True or false? 2)
3.3
16.5
5) Stocks/Bonds are normally riskier than bonds/stocks. True or false? 2)
4.6
13.8
6) Considering a long time period (for example 10 or 20 years), which asset 70.1
normally gives the highest return: savings accounts, bonds or stocks?
20.6
9.4
7) Normally, which asset displays the highest fluctuations over time: 88.8
savings accounts, bonds, stocks?
3.7
7.5
8) When an investor spreads his money among different assets, does the 81.2
risk of losing money increase, decrease or stay the same?
12.9
5.9
81.7
___________________________________________________________________________________
1) See exact wording in the text;
2) This question has been phrased in two different ways.
Note: Correct, incorrect and do not know responses do not sum up to 100% because of refusals. Adapted from Lusardi and
Mitchell (2007c).
22
Table 2B. Advanced literacy: Summary of responses
Weighted percentages of total number of respondents (N=812)
_________________________________________________________________________________
Number of correct, incorrect and do not know answers (out of eleven questions)
____________________________________________________________________
None
1
2
3
4
5
6
7
All
Mean
____ ____ ____ ____ ____ ____ ____ ____ ____
_____
Correct
.7
2.7
3.6
6.2
8.9
13.3
17.7
25.6
21.4
5.9
Incorrect
35.6 33.0
18.4
8.1
3.5
1.5
0
0
0
1.2
Do not know 56.5 18.7
11.0
6.3
3.3
1.9
.6
1.2
.5
1.0
_________________________________________________________________________________
Note: Categories do not sum up to 100% because of rounding. Adapted from Lusardi and Mitchell (2007c).
Table 3: Empirical Effects of Financial Literacy on Retirement Planning
Probability of Being a Retirement Planner
Correct Percentage Calculation
Correct Lottery Division
Correct Compound Interest
I
-.016
(.061)
.059*
(.030)
.153***
(.035)
II
-.012
(.062)
.034
(.031)
.149***
(.035)
.021
(.068)
-.154***
(.050)
-.114
(.080)
III
-.034
(.060)
.001
(.032)
.114***
(.039)
.054
(.067)
-.141***
(.051)
-.073
(.081)
No
.031
No
.038
Yes
.074
DK Percentage Calculation
DK Lottery Division
DK Compound Interest
Demographic controls
Pseudo R2
Note: This table reports Probit estimates of the effects of literacy on planning; marginal effects reported. Analysis
sample consists of HRS Early Baby Boomers who responded to financial literacy questions. Being a planner is
defined as having thought a little, some, or a lot about retirement. Demographic controls include age, education,
race, sex, marital status, retirement status, number of children, and a dummy variable for those not asked the
question about interest compounding. Regressions also include dummies for political literacy (knowing the
President and Vice President of the United States). DK indicates respondent who did not know the answer.
Observations weighted using HRS household weights. The total number of observations is 1,716. * Significant at
10% level; ** significant at 5%level ; *** significant at 1% level. Adapted from Lusardi and Mitchell (2007a).
23
Table 4: The Effect of Retirement Seminars on Retirement Accumulation
Total sample
a. Financial net worth
Total sample
Low education
High education
b. Total net worth
Total sample
Low education
High education
c. Total net worth +
Pensions and Social
Security
Total sample
Low education
High education
1st quartile
median
3rd quartile
17.6 %**
19.5%
13.1%
78.7%**
95.2%**
70.0%**
32.8%**
30.0%**
19.4%**
10.0%
8.8%
10.2%
5.7%
3.4%
7.3%
29.2%**
27.0%**
26.5%**
8.7%
7.1%
6.5%
0.5%
4.0%
3.6%
16.0%**
12.7%**
17.7%**
18.6%**
14.7%**
25.4%**
20.4%**
12.7%**
25.8%**
17.2%**
9.5%**
17.0%**
Note: This table reports the percentage changes in different measures of retirement accumulation resulting from
attending retirement seminars. Financial net worth is defined as the sum of checking and savings accounts,
certificate of deposits and Treasury bills, bonds, stocks, IRAs and Keoghs and other financial assets minus shortterm debt. See Table 1 for the definition of total net worth. * significant at the 10% level ** significant at the 5%
level. Adapted from Lusardi (2004).
24
Figure 1: Financial Literacy: By Age
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Compound Interest
Inflation
Stock Risk
≤ 60
75.88%
80.79%
59.95%
61-70
67.22%
79.72%
54.01%
> 70
57.63%
64.89%
42.61%
25
Figure 2: Financial Literacy: By Gender
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
26
Compound Interest
Inflation
Stock risk
Male
74.70%
82.20%
59.30%
Female
61.90%
70.50%
47.50%